Advances in Management & Applied Economics, vol.1, no.1, 2011, 1-14
ISSN: 1792-7544 (print version), 1792-7552 (online)
International Scientific Press, 2011
Does Increased Price Competition Reduce Entry
of New Pharmaceutical Products?
David Granlund1
and
Niklas Rudholm2
Abstract
In October 2002, a substitution reform was introduced in the Swedish
pharmaceuticals market. In this paper, the effects of increased price competition
due to the reform on the entry of new pharmaceutical products were studied. The
results show that the reform did affect the entry behavior of generic manufacturers
as they became more prone to enter new package sizes into the market after the
reform, but also that there is considerable heterogeneity in entry behavior between
different ATC-code groups for both brand name and generic products.
JEL classification numbers: D80, D83, L65, I11
Keywords: Pharmaceutical industry, generic competition, generic drugs, brand
name drugs.
1
2
The Swedish Retail Institute, SE-103 29 Stockholm, Sweden and Department of
Economics, Umeå University, SE-901 87 Umeå, Sweden.
The Swedish Retail Institute, SE-103 29 Stockholm, Sweden and Department of
Economics, Dalarna University, SE-781 88 Borlänge, Sweden,
e-mail: niklas.rudholm@hui.se
Article Info:
Revised : March 29, 2011.
Published online: May 31, 2011
2
1
Does Increased Price Competition.…
Introduction
A substitution reform that came into effect on October 1, 2002 increased the price
competition in the Swedish pharmaceuticals market. 3 When the reform was
introduced, there was a debate in Sweden that pharmaceutical firms would
increase product diversity with more different types of pharmaceutical products
(more drugs being sold as pills, oral fluids, etc instead of just as pills) and more
different package sizes. The reason for this belief was that pharmaceutical firms
by doing so could avoid the increased price competition between exchangeable
products since the rules state that exchange is only possible for products of the
same type and package size.
There are several studies during the 1980ties and 1990ties that directly addressed
the issue of what determines generic entry into pharmaceuticals markets. In an
early study, Yu (1984) found that price differences between brand name and
generic manufacturers had a negative effect on entry into the market. She also
found that market growth, measured as the growth in the number of prescriptions,
had a positive effect on entry and that the rate of innovation had a negative impact
on entry, suggesting that new drug inventions were a deterrent to entry.
Grabowski and Vernon (1992) investigated generic entry for 18 brand name drugs
in the U.S. pharmaceuticals market, and found that generic entry was significantly
affected by profitability. In a study of 81 different medical substances between
1987 and 1994, Bae (1997) found that generic drug entry was faster in markets
where the sales revenue of the brand name manufacturer was large and that entry
was faster in markets for drugs that primarily treat chronic deceases.
Scott-Morton (1999) studied entry by generic manufacturers into the US
pharmaceuticals market between 1984 and 1994. She found that firms tend to
3
The reform, the characteristics of the reform that made consumers more price sensitive
and the effect that this has had on pharmaceutical prices is described in detail in Granlund
and Rudholm (2011) and Granlund (2009).
David Granlund and Niklas Rudholm
3
enter markets with characteristics similar to the markets in which the firm is
already established. In addition she reports that pharmaceuticals which are
characterized by high revenues from sales of the brand name product, large
amount of hospital sales, and treatment of chronic conditions, attract more generic
entrants compared to other markets.
More recent studies include Rudholm (2001), Kyle (2007), Ilzuka (2009) and
Moreno-Torres et al (2009). Rudholm (2001) reports that potential profits have a
positive effect on entry, while the length of patent protection for the incumbent
brand name drug has a negative effect on generic entry. Both Ilzuka and
Moreno-Torres et al. report that the level of revenues are positively correlated
with generic entry, while Kyle reports that price regulations in one country might
reduce generic entry in other countries.4
In this note, the Swedish substitution reform will be used as a natural experiment
to study the causal effect of increased price competition on product diversity.
More precisely, we study whether or not pharmaceutical firms have responded to
the reform by launching products in new segments of the market, thus avoiding
increased price competition due to the reform. Our focus is thus on entry of new
exchange groups as defined by the Swedish Medical Products Agency, or
alternatively, on entry of new package sizes into already existing exchange
groups.
As mentioned above, the substitution reform will affect the profitability of
pharmaceutical products since it makes consumers within an exchange group
more cross-price-sensitive and this affects revenues (Granlund and Rudholm,
4
A number of studies have also suggested that generic competition affects brand name
prices and market shares. These studies include Caves et al. (1991), Hudson (1992),
Grabowski and Vernon (1992), Frank and Salkever (1997), Suh et al. (2000), Aronsson et
al. (2001), and Regan (2008). One notable finding is that in several of these papers,
generic entry is associated with an unexpected increase in brand name prices.
4
Does Increased Price Competition.…
2011). As for the costs of entering and being active in an exchange group, the
application fees for entering a product into a new exchange group is SEK 70 000
and SEK 40 000 for additional products in the same application. For firms
entering an already existent exchange group that fee is SEK 20 000. The yearly
administrative fee for being active in the market is SEK 16 000 for each
additional product in each exchange group (SFS 1993:595).
Firms will choose to enter a new product into the market (or to introduce a new
package size for an already existing product) if they believe that they can make an
economic profit doing so. Brand name firms can do this either before or after the
patent expires. Entering new products before patent expiration has two advantages,
it leaves the brand name producer as monopolist until patent expiration and it
helps create consumer loyalty to the brand name product which is valuable to the
firm (for a discussion regarding consumer loyalty see e.g. Granlund and Rudholm,
2009). Both of these effects increases the probability that establishing a new
exchange group (i.e. entering a new product) will be profitable for the brand name
firm. If entering after patent expiration, the brand name firm must incorporate the
probability of rapid generic entry and price competition in the new exchange
group into its entry decision. The brand name producer will thus enter a new
exchange group if and only if they believe that they can make a positive economic
profit (including all entry and production costs) before entry drives down price to
long run marginal cost. Generic firms might also enter new exchange groups into
the market, but it should be noted that the risk of rapid brand name entry into the
same exchange group would be considerable bearing in mind that brand name
producers have profits from the time as monopolist that can help finance entry
costs.
The above reasoning leads to the following testable hypothesis. First, since the
substitution
reform
has
increased
price
competition
in
the
Swedish
pharmaceuticals market (Granlund and Rudholm, 2011), pharmaceutical firms
could establish new exchange groups into the market to avoid the increased price
David Granlund and Niklas Rudholm
5
competition caused by the reform. Second, brand name producers should be more
prone to establish new exchange groups before patent expiration rather than after
due to the threat of rapid generic entry after patent expiration. Third, both brand
name and generic producers should be more prone to enter new package sizes into
an already existing exchange group as compared to entering new exchange groups
altogether since there are no administrative costs associated with entering a new
package size.
2
The Swedish pharmaceuticals market and the substitution
reform
The substitution reform came into effect on October 1, 2002. The reform required
that pharmacists inform the consumers if there are substitute products available, as
well as that the cheapest available substitute product would be provided within the
Swedish pharmaceuticals insurance system. The pharmacist must also inform the
consumers that they can buy the prescribed pharmaceutical product instead of the
generic if they pay the difference in price between the products themselves.
Finally, the reform requires that pharmacists substitute the prescribed
pharmaceutical product to the cheapest available generic in cases when neither the
prescribing physician prohibits the switch for medical reasons, nor the consumer
chooses to pay the price difference between the prescribed and the generic
alternative. In cases where the physician prohibits the switch due to medical
reasons the consumer is still reimbursed.
Pharmaceutical firms decide which prices they charge for pharmaceuticals in
Sweden, but for products to be included in the Swedish pharmaceuticals insurance
system the price charged by the pharmaceutical firms has to be authorized by the
Pharmaceutical Benefits Board. Pharmaceuticals are sold through a nation wide
government owned monopoly, the National Corporation of Swedish Pharmacies
(NCSP), which has a margin on the pharmaceutical products that is determined by
6
Does Increased Price Competition.…
the Pharmaceutical Benefits Board. The regulations also imply that the NCSP is
required to charge a nationwide uniform price for each pharmaceutical product in
Sweden.
Before the substitution reform, a reference price system introduced in January
1993 was in effect.5 Under that system, the Swedish National Social Insurance
Board set a reference price equal to 110 percent of the price of the cheapest
available generic product, and all costs exceeding this reference price were to be
borne by the consumer (RFFS 1992:20, 1996:31).
Some additional aspects of the substitution reform also deserve mentioning. First,
the out-of-pocket cost for patients changed when the reference price was abolished.
Under the substitution reform costs up to 100% of the cheapest generic alternative
is included in the pharmaceutical insurance system, compared to 110% during the
reference price system. This increased the patients out-of-pocket costs for
choosing to buy the prescribed pharmaceutical with 0-10% of the price of the
cheapest generic version, depending on the patient's co-payment rate in the
insurance system. On average this means an extra out-of-pocket cost of
approximately 12.50 SEK (≈ 1.3 EURO).6 Second, the transaction cost of generic
substitution was lowered when the reform was introduced in 2002, which could
also affect entry behavior.7
5
The effects of the reference price system on pharmaceutical prices have been analyzed
previously, see e.g. Aronsson et al. (2001), Rudholm (2001) and Bergman and Rudholm
(2003).
6
The calculation is based on the fact that the average price of the prescribed products
and the available substitute products in the substitution system was approximately 300
SEK and 250 SEK, respectively, and a patient co-payment rate of 50%. 9.48 SEK = 1
EURO, exchange rate 2007-08-15.
7
Before the reform physicians had to be contacted in order for a substitution to take place.
We have not been able to find any studies of how common it was for prescribing
physicians to allow generic substitution before the reform. However, during the first 15
months after the substitution reform, physicians choose to deny the exchange in only 3
percent of the cases (National Corporation of Swedish Pharmacies et al., 2004).
David Granlund and Niklas Rudholm
3
7
The empirical analysis
IMS Sweden has provided a dataset containing information on all pharmaceutical
products sold in Sweden during the period January 1997 until October 2007. In
this paper, our focus is on entry of new exchange groups as defined by the
Swedish Medical Products Agency. As such, the data is aggregated so that an
observation of our dependent variable equal to one represents the entry of one (or
more) new exchange groups within a given seven-figure ATC-code8, or entry of
one (or more) new package sizes into an already existing exchange group, in a
given month.9
The estimations are conducted for both brands and generics, and the total number
of observations in the dataset used in the estimation for brand name drugs equals
40973, while the number of observations related to generics equals 14108.
Descriptive statistics for both types of dependent variable (exchange group and
package size) and the variables used in the estimation of equation (1) are
presented in Table 1 for both brand name and generic products.
Table 1: Descriptive statistics
Variable
entry (new exchange group)
entry (new package size)
t
reform
patent
Observations
8
Brand name drugs
Mean
Std. Dev.
0.0078
0.88
0.026
0.16
69.14
36.90
0.51
0.49
0.27
0.44
40973
Generic drugs
Mean
Std. Dev.
0.0099
0.099
0.059
0.24
74.02
37.56
0.57
0.49
n.a.
n.a.
14108
In the World Health Organization's Anatomical Therapeutic Chemical (ATC)
classification system, the drugs are divided into different groups according to the organ or
system on which they act, and their chemical, pharmacological and therapeutic properties.
In the ATC-groups used here, drugs which share the same chemical substances are
grouped together.
9
We choose to study the probability of one or more entrants within a specific month
instead of the number of entrants since entry of more than one new exchange group
within a specific month is rare in our sample.
8
Does Increased Price Competition.…
The following equation is then estimated for both brand name products and
generics;
entry it = β 0 + β 1t + β 2 reformt + β 3 patent it + u it
(1)
where entry represents the establishment of a new exchange group (entry of a new
type of pharmaceutical product) as defined by the Swedish Medical Products
Agency or entering a new package size into an existing exchange group. t is a time
trend, reform is a indicator variable taking the value one after the introduction of
the Swedish substitution reform in October 2002, patent represents our proxy for
patent expiration10, and uit is the residual term. The time trend is included to
capture possible time trends in entry behavior (due to, for example, time-trends in
revenues and/or profits, costs etc.).
One could consider other potential covariates such as the number of generic
competitors, revenues etc. However, using these variables introduces econometric
problems, due to the fact that these variables are endogenous in the sense that they
will be correlated with the error term of the regression. Instead of including these
problematic covariates, we opt for using a random effects, random coefficient
model to account for heterogeneity between ATC-code groups in both average
entry behavior and the effects of the reform on entry behavior. The residual (or
heterogeneity) term is specified as
u it = v i + γ i reformt + ε it
where
(2)
v i ~ iidN (0,σ v2 ) is a ATC-code random effect, γ i ~ iidN (0,σ γ2 ) is a
ATC-code specific random coefficient term related to the introduction of the
substitution reform, and ε i ~ iidN (0,σ ε2 )
10
is the within ATC-code group residual.
In this paper, the time of generic entry is used as a proxy for patent expiration. Thus,
the variable patent is an indicator variable taking the value one after entry of the first
generic competitor into each exchange group.
David Granlund and Niklas Rudholm
9
The specific random effects are assumed independent of each other, and the model
to be estimated can thus be written
entry it = β 0 + β1t + v i + (γ i + β 2 )reformt + β 3 patent it + ε it
(3)
The main advantages of this type of model is that it accounts for ATC-code
specific unobserved heterogeneity in entry behavior, while also allowing for
heterogeneity in how the reform affected different ATC-code groups with respect
to entry behavior.11 The results from the estimations are presented in Table 2.
Table 2: Estimation results
Brand name drugs
Generic drugs
New group
New size
New group
New size
Parameter (variable)
Estimate
S.e.
Estimate
S.e.
Estimate
S.e.
Estimate S.e.
β_0
0.012*
0.0017
0.036*
0.0030
0.020* 0.0042
0.061* 0.026
β_1(t)
-0.000049* 0.000023 -0.00011* 0.000043 -0.000060 0.000046 -0.00058* 0.00010
β_2(reform)
0.0026
0.0019
0.0030
0.0035 -0.0017 0.0038
0.029* 0.0095
β_3(patent)
-0.0033
0.0020
-0.0024
0.0034
n.a.
n.a.
n.a.
n.a.
Random effect/random coefficient parameters (variable)
0.026*
0.0012
0.043*
0.0021
0.042* 0.0040
0.078* 0.0072
vi
0.016*
0.0013
0.033*
0.0023
0.018* 0.0032
0.051* 0.0065
γi(reform)
Log-likelihood
42609
18172
12782
798
Observations
40973
40973
14108
14108
ATC-codes
391
391
178
178
* Significant at the 5 percent level.
The population mean coefficient for the average effect of the exchange reform on
entry of new exchange groups for brand name drugs and generics are 0.0026 and
-0.0017, respectively. Neither of these parameter estimates are statistically
significant at conventional levels. We can also use the estimation results to
calculate an interval within which 95% of the estimated coefficients ( γ i + β 2 )
related to the reform effect are expected to lie (Rabe-Hesketh and Skrondal, 2008,
11
Conventional random effects models have also been estimated. All qualitative results
presented in this paper remain the same.
10
Does Increased Price Competition.…
p. 159). Doing this we obtain 0.0026 ± (1.96*0.016) for brands and -0.0017 ±
(1.96*0.018) for generics. As such, 95 percent of the coefficients ( γ i + β 2 ) for the
effects of the reform on entry of brand name product exchange groups will be
between -0.029 and 0.034. The same numbers for generics are -0.037 and 0.034.
For entry of new package sizes within an already existing exchange group, the
estimate of the average effect for all ATC-code groups is statistically insignificant
for brands, but significant on the 5 percent level for generics. The size of the
parameter estimate indicate that the probability of a generic entering a new
package size into an already established exchange group is increased by 2.9
percent by the substitution reform. Calculating the same type of confidence
interval as above, the results show that 95 percent of the coefficients for the
effects of the reform will be between -0.071 and 0.13, respectively. As such, the
results show that there is considerable heterogeneity between ATC-code groups in
how the reform has affected both the establishment of new exchange groups and
the entry of new package sizes in already established exchange groups. It should
also be noted that the variance components for both random effects and random
coefficients are statistically significant, indicating that not including these in the
estimations would lead to biased parameter estimates.
4
Discussion
In this paper, the substitution reform implemented in Sweden in October 2002 has
been used to study the causal effect of increased price competition on product
diversity. When the reform was introduced, there was a debate in Sweden that
pharmaceutical firms would increase product diversity with more different types
of pharmaceutical products and more different package sizes. The reason for this
belief was that the pharmaceutical firms by doing this could avoid the increased
price competition due to the reform since the rules state that exchange is only
possible for products of the same type and package size.
David Granlund and Niklas Rudholm
11
The three following hypotheses was formulated and tested in this paper. First,
since the substitution reform has increased price competition in the Swedish
pharmaceuticals market (Granlund and Rudholm, 2011), pharmaceutical firms was
expected to establish new exchange groups to avoid the increased price
competition caused by the reform. Second, brand name producers should be more
prone to establish new exchange groups before patent expiration rather than after
due to the threat of rapid generic entry after patent expiration. Third, both brand
name and generic producers should be more prone to enter new package sizes in to
an already existing exchange group as compared to entering new exchange groups
altogether since there are no administrative costs associated with entering a new
package size.
The results in this paper show that the reform has not, on average, affected the
entry behavior of brand name pharmaceutical firms, but also that there is
considerable heterogeneity between ATC-code groups in the effects of the reform.
For generics, there is a positive correlation between the introduction of the reform
and the average level of entry of new package sizes into already existing exchange
groups. However, using the size of the ATC-code specific random coefficient to
calculate a confidence interval for the effects of the reform, the results show that
95 percent of the ATC-code specific coefficients for the effects of the reform will
be between -0.071 and 0.13, respectively. As such, the results show that there is
considerable heterogeneity in how the reform has affected both the establishment
of new exchange groups and the entry of new package sizes in already established
exchange groups.
ACKNOWLEDGEMENTS. A research grant from the Swedish Competition
Authority is gratefully acknowledged.
12
Does Increased Price Competition.…
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